Imperfect markets VS imperfect regulation

On the role of governments in the electric power industry

As I am reading Sebastian Mallaby’s excellent new biography of Alan Greenspan, former Chairman of the US Federal Reserve, I am reminded how central and complex is the question of the appropriate role of governments and law-makers in the operation of the economy. Since Industrial Organisation economists debunked the Chicago critique in the late 1980s, no one really doubts that markets are imperfect: left to their own devices, they are likely to lead to concentration and inefficient risk-sharing. On the other hand, the debacle of the Soviet Union, but also countless examples of underproductive government interventions and regulations, are evidence that governments, law-makers, and bureaucracies are not able to run economies.

Thus, like Alan Greenspan at the helm of the Fed, we are struggling to find the appropriate level of government intervention. This applies to all industries, but perhaps more so, to the power industry. Since the electricity fairy has enlightened millions of us on her patch, we emotionally consider electricity a necessity, hence expect governments to guarantee its provision.

This article explores governments’ intervention in four aspects of the power industry: (I) generation adequacy, (II) generation mix, (III) organisation of the transmission grid and (IV) asset ownership.

Generation adequacy

Following an afternoon of tight supply and demand conditions, which almost led to rolling blackouts in Great Britain in October 2015, David Cameron, then Prime Minister, called an emergency cabinet meeting to ensure that the “lights remain on”. I found this particularly startling, coming from Prime Minister who appeared not to be overly concerned by a widening income distribution or by cuts in the NIH.

To meet that government promise, Great Britain, like many other countries and US states, has implemented a capacity market. Over the years, I have read most of the academic literature on these capacity mechanisms. All articles start from the premise that setting a generation adequacy standard (i.e., setting an acceptable number of hours of rolling blackouts per year on average) falls within the governments’ responsibilities.

A generation adequacy standard was a legitimate engineering practice when spot markets did not exist, hence when consumers had no information to reduce their consumption in response to scarcity. It is no longer required today. And yet, we continue to use a generation adequacy standard, and furthermore entrust our governments with the responsibility of setting it. Should we not at least discuss whether we need such standard, and who should set it? We may conclude, after carefully weighing the pros and cons, to continue with the current practice. Or we may conclude, like the people of New Zealand, that a generation adequacy standard is no longer required. Whatever the outcome, we would at least collectively make a conscious decision.

Generation mix

In planned economies, governments choose the power production technologies. Civil servants examine the different technologies available at a given time, compare their costs, and determine the optimal mix. In the vertically integrated and regulated monopolies of old, utility planners were performing this task, in cooperation with civil servants.

One of the main objectives of industry restructuring was to put an end to central planning, and let competing investors choose the technology mix. Market discipline is supposed to increase productive efficiency, hence net surplus: if a firm chooses an inefficient technology, its profits will suffer, and the technology will be abandoned, and the firm may go bankrupt. Markets appear to have performed well in the 1990s: in Great Britain for example, high cost and polluting coal fired power plants were replaced by more efficient and cleaner combined cycle gas turbines.

However, since the mid 2000s, European governments are back in the business of choosing the power production mix. For example, the German government has decided to phase off nuclear production, while at the same time the British government has decided to launch a new generation of nuclear assets. Meanwhile, all European governments have heavily subsidized Renewable Energy Sources, in effect administratively setting the generation mix.

The justification for these interventions is not completely clear. It is not obvious that the specific choice of technologies is a political issue, which falls under the purview of elected officials. Of course, safety and regulatory agencies are responsible to ensure that assets are operated safely. Of course, governments and law-makers should correct for externalities, for example by introducing a price for carbon and other pollutants. However, these legitimate interventions do not justify choosing the technology mix.

On the other hand, the problems associated with governments’ choosing the technology mix are quite clear. First, this creates uncertainty for investors. Market prices are no longer determined by economic fundamentals, such as fuel costs, but by government fiat. Since the latter are much less predictable than the former, investors have difficulties anticipating them. Regulatory uncertainty is an important driver of underinvestment in all industries, including the power industry.

Second, the winning technologies are these that secure more favorable treatment from the governments, not necessarily the most efficient. Lobbying prowess, not technological innovation, is the key driver of financial performance.

Finally, decisions makers are not accountable. If a corporation’s management team chooses an inefficient technology, chances are investors will request a change of team. Experience suggests that the public’s appetite to hold elected officials — and bureaucrats — to account for such mistakes is much more limited. These lower incentives are unlikely to translate in better choices.

We pointed out the absence of strong justification for governments’ intervention in the generation segment of the power industry, and the damages these interventions create. By contrast, we will now discuss how European governments could increase net surplus by intervening in transmission pricing. Sadly, they show little inclination to do so.

Transmission pricing

The transmission grid is the core of any power system. It improves economic efficiency and reliability. By connecting producers and consumers, the grid makes economic exchanges possible, hence increases the net surplus. By offering multiple paths for these exchanges, it lowers the probability of failure of (parts of) the system, hence increases expected net surplus.

Engineers, economists, and policy makers have long recognized the central role of the transmission grid. When the industry was restructured in the 1990s, stakeholders devoted significant attention to the grid, in particular transmission pricing. The issue differs from standard transportation pricing problems since transmission lines are sometimes congested (or constrained): when a line’s transfer capacity limit is reached, it is impossible to increase the power flowing on it.

After a few years of a technical — yet lively — debate, most observers agreed that the correct approach is — somehow surprisingly — not to price usage of the transmission grid, rather to let energy prices vary across locations and times, to reflect marginal losses and congestion costs. This approach, known as “nodal pricing”, has been adopted in all markets except Europe, where a variation known as “zonal pricing” has been implemented. In essence European power exchanges recognize the existence of transmission constraints between countries, but ignore constraints within each country. The task of managing within-country congestion is left to the national Transmission System Operators (TSOs).

“Zonal pricing” could work if within-country congestion was negligible. Alas, this is not the case today, and the situation is likely to worsen, as new Renewable Energy Sources (RES) are constantly added to the grid. Since Not In My Back Yard (NIMBY) considerations make massive expansion of the grid unlikely in the short-term, congestion, both between- and within-countries will increase over the next 10 years. A recent academic study[1] finds that the adoption of nodal pricing would reduce system variable costs (mainly fuel) from €0.8 — €2.0 billion depending on the penetration of wind power.

How do policy makers respond to this situation? The European Commission, through various arms, has been pushing for increased market integration. Imperfect as it is, “zonal pricing” is a significant improvement compared to previous practices. It is the result of a concerted and sustained effort to “couple” national markets, which deserves to be applauded.

However, the process appears to be stalling today. While the European Commission has launched a recent initiative for further integrate regional markets as a precursor to full market integration[2], few TSOs and market participants are enthusiastic supporters of nodal pricing, as this would require significant changes to their market making software and operations.

This situation looks like a standard case of market failure: nodal pricing increases net surplus, but imposes private costs on industry participants. Government intervention is legitimate, even required, to push the industry towards a more efficient market organisation. However, most national governments refuse to entertain nodal prices, as these would recognise that the value of electric power is not uniform within each country. To maintain the fiction of equal prices throughout their country, they prefer to increase the cost to consumers by up to € 2.0 billions per year. A valuable opportunity for government intervention thus goes unfulfilled.

Having explored governments’ intervention pointing out the absence of strong justification for governments’ intervention in the generation side of the power industry, and the damages these interventions create, we lamented the absence of a strong push from European government to move towards efficient pricing of transmission services. We now focus on a more complex topic, the role of government in selecting owners of electricity assets.

Asset ownership

Asset ownership was very simple after 1945. In most countries, power utilities were state-owned. In the US, the majority of utilities were owned by private and domestic investors, and heavily regulated. The restructuring of the industry in the 1990s transformed this equilibrium: European corporations purchased US power assets (e.g., National Grid Company successive purchases in the Northeast of the US), and symmetrically, US utilities invested in European assets (e.g., Entergy purchase of London Electricity). Within Europe, cross-border acquisitions were numerous (e.g., EDF acquisition of EnBW, Enel acquisition of Endesa). More recently, Chinese investors have rolled up European transmission and distribution assets. This raises the issue of the appropriate level of foreign ownership in a domestic power industry.

Contrary to the topics covered in the previous parts, no simple answer exists for this question. On the one hand, if a foreign firm is better able to run a business than the domestic ones, why should domestic consumers be deprived of the benefits of increased efficiency? In the late 19th century, global electrification was led by international companies, which had mastered this emerging technology, not necessarily by domestic ones. A contrario, examples abound of domestic industries, which, being shielded from international competition by protective regulation, progressively become inefficient. Following this view, the role of the government is to regulate the industry, i.e., to guarantee that foreign and domestic operators respect all relevant laws, and treat customers fairly.

This policy was adopted in Great Britain following industry restructuring in 1990. Today, four of the six large vertically integrated electricity producers and retailers are foreign-owned: EDF Energy is owned by the French utility EDF, E.ON UK by the German utility E.ON, npower by the German utility RWE, and ScottishPower by the Spanish utility Iberdrola. Neither the British government nor the British public appears unduly alarmed by this situation. In many respect, this is a success story: foreign investors were attracted to Great Britain by the clarity, stability, and perceived fairness of its regulatory institutions, and committed capital to deliver power to British customers.

On the other hand, foreign ownership raises a series of issues. First and foremost is national security. Even though Karla and Smiley[1] are by now retired, governments would be foolishly naïve to ignore industrial espionage and its accompanying “cloak and dagger” world. Power assets are vital to national security, and highly vulnerable: a prolonged power outage (caused for example by a computer virus) would have devastating impact on any country. Governments are therefore legitimate in ensuring that power assets be operated at the highest security standard. This may lead to restrictions on foreign ownership.

Second is technological leadership. Unprecedented technological innovations are currently reshaping the power industry. Can a country whose power industry is largely foreign-owned remain at the frontier of innovation? While there is no guarantee, experience shows that even foreign-owned companies are … somehow domestic, i.e., they employ local contractors, and forge research partnerships with local firms and local universities.

Finally is political acceptance. In many countries, globalisation and foreign ownership are today viewed with suspicion, if not hostility. The public mistrust of the six largest utilities in Great Britain is mostly due to raising energy prices and dismal quality of service, but also probably partly to their being foreign. This concern is exacerbated by citizens’ low confidence in their government ability to effectively protect them against unfair practices. Better and stronger regulation is the obvious answer, but hard to achieve.

This article has explored various government interventions into electricity markets. A common theme emerges: for political reasons, national governments feel compelled to intervene and “optimise” electricity markets, so as to correct perceived failures or promote specific policies.

The risk for the industry — and for the population at large — is that these interventions create a thick web of rules and regulations, which will slow down innovation. The power industry is on the cusp of a massive technological renewal. It would be a shame if government meddling, however well-intentioned, were to slow it down.

This article was originally published on the Florence School of Regulation website in 4 parts for the ‘Topic of the Month’ in December 2016.